A Growth Tip for Founders: Maybe Don't Accept Funds from Family

Entrepreneurs from Jeff Bezos to Michael Dell have turned to family and friends for initial cash, but few startups go on to become Amazon or Dell Technologies. In fact, accepting that informal infusion may short-circuit what many young companies need most: growth.

Founders who depend on investment from parents, family members, or close friends are less apt to take risks and grow more slowly than when funding comes from an outside source like venture capital firms or angel investors, finds research by Brian Baik, an assistant professor at Harvard Business School.

Examining detailed data from Norway, researchers show that rates of return for family investors were 7.5 percentage points lower than those for comparable professional investors.

Baik designed a working paper to investigate why, and his conclusions reflect the complex psychology of friends-and-family relationships. Family investors are driven by a desire to help and protect their relatives and close friends from financial danger, he explains. Entrepreneurs, in turn, could fear losing a parent’s retirement savings or damaging a close relationship.

“When family investors invest in a startup firm, there is an association with lower risk-taking, broadly lower performance, or lower probability of receiving sophisticated financing,” Baik says. “The fact that family investors invest in that startup doesn't necessarily cause the firms to take fewer risks. It's more because of altruism—where family members select firms with perceptibly lower quality or firms that are just taking fewer risks to begin with.”

In the United States, informal financing supports 3.8% of all startups versus 0.5% for VC funding. Getting illustrative data has proven challenging, however, as informal investments are rarely disclosed in commercial datasets.

Focusing on Norway offers a unique window, as available data there includes identifiers such as family relationships and personal wealth, and Norway hosts innovation hubs that aim to grow new firms.

Baik coauthored the paper “Family Financing in Startups,” released earlier this year and updated in August, with Johan Ludvig S. Karlsen, a professor at the BI Norwegian Business School, and Katja Kisseleva, a professor at the Frankfurt School of Finance & Management.

Detailed data from Norway

The researchers focused on Norwegian tax declarations for private limited liability companies, or LLCs, from 2004 to 2018. With at least four cities considered major innovation hubs, Norway has a thriving startup scene.

Unique labels allowed the researchers to glean deeply detailed information about each firm, such as identifying founders and board members to help confirm family and other relationships.

Using a sample of more than 46,121 “potentially innovative” Norwegian startups, the authors narrowed their focus to 4,460 companies with informal investors contributing at least 10,000 Norwegian krone (about $1,500).

Informal investors were identified as a family member of the entrepreneur through the relationship data provided by the Norwegian Tax Authority the year each firm was incorporated.

Lower sales, fewer patents

Overall, family-backed entrepreneurs had 53% fewer patents than those supported by professional investors. The authors also found that, compared with outside investors, firms with informal investors had:

• Almost 7 percentage points slower sales growth.

• Intangible assets worth 2.2 percentage points less.

• About 1.8 percentage points lower R&D expenses.

Another important finding: Startups take family and friend financing much earlier than funding involving a VC, angel, or other external investor. Informal investors dove in during the first four months after a startup’s launch, on average, while investments from angel investors came when a startup was about 4.3 years old.

When families manage risk

The authors found that family investors select ventures that take fewer risks. The entrepreneurs themselves do not make decisions more conservatively than they otherwise would, says Baik, and founders who may be more risk averse gravitate toward family financing.

That doesn’t mean an investing family member is naive. In fact, the cautious behavior persists even when informal investors are experienced and wealthy.

Family investors seem to be driven by altruism and supporting a friend or family member’s dream, says Baik. The authors tested how behavior changes the closer—or further away—the informal investor lives from the founder, finding that investors who share the home with the founder and are presumed to be emotionally close are even less concerned with growth.

When ‘a little help from my friends’ is helpful

The perception in the industry, anecdotally, tends to be that taking family money may be a last resort. The findings show "that's not necessarily the case," Baik says.

Baik advises entrepreneurs and investors to view each situation on a case-by-case basis. If they’re starting a company with a parent’s life savings, it’s natural for an entrepreneur to be a little risk averse. However, Baik recommends that founders focus on expanding their business, rather than making enough profit to repay a family member.

“They'll have to treat the family members as any other investors,” he says. “That's, I think, what makes startups take risks, innovate more, and ultimately increase the chance of becoming a large success.”

Illustration: Ariana Cohen-Halberstam with photo from AdobeStock/Peshkova